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Summary

  • Taiwan Semiconductor will benefit from demand for low-end smartphones and China's push into 4G.
  • Orders from Apple will benefit Taiwan in the long-run.
  • Taiwan Semiconductor is a great buy at present valuation.

Taiwan Semiconductor Manufacturing (NYSE:TSM) is one of the world's leading foundries, and its dominance reflects in its stock price performance. Taiwan Semiconductor shares have gained 30% so far this year, and after taking a look at its recent first quarter results, there is no doubt that its outstanding performance will continue.

Taiwan Semiconductor first quarter revenue increased 11.6% year-over-year. The gross margin was 47.5%, up 3 percentage points from the previous quarter, while the operating margin was 35.4%, up 2.6 percentage points from the fourth quarter. Net profit amounted to $1.59 billion, beating analysts' estimates of $1.45 billion by a wide margin.

Looking ahead, the momentum looks set to continue. The expected second-quarter revenue is between $6.02 billion and $6.12 billion, which is a 22% quarter-over-quarter increase, while the gross margin for the quarter is expected to be between 47.5% and 49.5%.

Growth drivers

Taiwan Semiconductor's growth is driven by strong seasonality, demand for low-end smartphones, China's push into 4G, and orders from Apple (NASDAQ:AAPL). The fast growth in mobile computing and network/cloud infrastructure is driving demand for complex semiconductor devices, improving Taiwan's prospects. It holds a solid position in the industry, while giving tough competition to companies like Samsung and Intel (NASDAQ:INTC). Taiwan Semiconductor's 20-nanometer technology is projected to generate 20% of its total revenue this year, with Apple contributing almost half of that.

Last week, The Wall Street Journal reported that in an attempt to diversify its revenue stream, Taiwan Semiconductor has started shipping microprocessors to Apple. For years, Samsung was the sole supplier of microprocessors; however, it seems that Taiwan Semiconductor has gained the upper hand as it will also supply the next generation of A-series processors to Apple. Analysts estimate that Apple's microprocessor business will contribute about 10% to Taiwan Semiconductor's revenue.

Not only is Taiwan Semiconductor's 20-nm process smaller in size, it is also 30% faster, and consumes 25% less energy than Samsung's microprocessors. However, technical advantage isn't the only reason why Apple is planning to use Taiwan Semiconductor's microprocessors. Given the ongoing lawsuits and intense competition from Samsung, Apple wants to reduce its dependence on Samsung as its primary component supplier.

The Wall Street Journal also noted that "Apple will likely increase its orders from TSMC as the contract chip manufacturer doesn't compete directly with Apple in the consumer-electronics market as Samsung does." Thus, analysts expect Apple's contribution to Taiwan Semiconductor's revenue to rise to 15% in 2015.

Taiwan management expects the company to outpace the semiconductor industry, and this is a step in the right direction. Most of the Apple products which are to be launched this year are expected to use 20nm A8 mobile application processors produced by Taiwan Semiconductor.

Competitive climate

Taiwan Semicondunctor needs to stay ahead in process nodes, while still keeping pace with the volume needs and demands of its client base. The company's next node is the 16-nm node, which is expected to be taped out later this year or very early next year, while its rival Intel taped out the 14 nm node last year. Reports suggest that Apple and Taiwan Semiconductor are already working on the development of 16nm chips.

Intel plans to tape out 10-nm chips next year, while Samsung will tape out its 20-nm node this year. This indicates that Taiwan is ahead of Samsung, but behind Intel. While Intel claims its scaling advantages over Taiwan's approach, asserting a 35% advantage at 14nm/16nm and a 45% advantage at 10nm, Taiwan calls this misleading and claims that Intel's advantage at 14nm/16nm is less than half of what Intel claims, and that they are equal at 10nm. Thus, it's a bit confusing for analysts and investors to decide whether Intel or Taiwan has the better technology at 14nm/16nm, where it seems that both are likely to be viable and competitive processes.

Conclusion

Even after putting in a strong performance in 2014, Taiwan Semiconductor shares trade at reasonable valuations. The company has a trailing P/E ratio of just 18, while its forward P/E sits at under 15. This seems impressive for a company whose earnings are expected to grow at a CAGR of 15% over the next five years. So, investors should carefully consider Taiwan shares for their portfolio as it can deliver more upside going forward.

Source: The iPhone 6 Makes Taiwan Semiconductor A Buy